Economic Growth and Financial Market Development: A Strengthening Integration, Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund
August 22, 2007
Managing Director of the International Monetary Fund
at the 3rd International Derivatives and Financial Market Conference
Campos do Jordão, Brazil, August 22, 2007
As Prepared for Delivery
1. Let me begin by thanking Manoel Felix Cintra Neto for the invitation to this conference and President Meirelles for that very kind introduction.
2. I would like to talk to you this evening about the importance for emerging economies of developing strong, broad, and deep financial markets. At first sight, this may seem like a strange time to be emphasizing the importance of financial market development. Across the world there is heightened concern about the recent turbulence in credit markets. Indeed, the Fund warned of these risks in recent months, including those associated with carry trades, mergers, and complacency about credit risk. In recent weeks, we have seen the problems in the U.S. subprime mortgage market reverberate across global capital markets, requiring exceptional liquidity injections by central banks in the United States, Europe, and Asia.
3. This episode of turbulence represents the first real test of structured finance and related credit derivative markets, and of the complex instruments being traded in these markets. It should be said at the outset that these markets, which have grown rapidly in recent years, have brought many benefits. By enabling market participants to better diversify risk, the cost of credit has been lowered world-wide, and a much larger segment of the population has been able to access credit, providing an important boost to global growth.
4. However, some participants have under-estimated the risks related to both the liquidity and the pricing of these complex instruments. Deepening concern about the situation of a number of financial institutions exposed to these risks has had a significant impact on the liquidity of the interbank markets. Fortunately, a number of central banks throughout the world have been quick to react with significant injections of liquidity, with an aim to restoring orderly market conditions. Nevertheless, looking forward, there remains considerable uncertainty about the implications of the ongoing liquidity squeeze for financial markets and for the outlook for the real economy more broadly.
5. From the perspective of the International Monetary Fund, I would offer three observations regarding these recent developments and their implications. First, for the present, we still expect the global economy to continue performing well, even in the face of recent financial market turbulence. Second, although recent developments have highlighted some of the risks that come with innovations in financial instruments, we believe that these innovations provide an important and essential contribution to the sustained and rapid growth of both advanced and emerging market economies. Third, financial markets are still the surest route to growth and stability, if they are transparent and well-regulated, and if adequate provisions are made for consumer and investor protection. Let me take each of these themes in turn.
Global fundamentals and markets
6. The economic fundamentals, both in the large industrial economies and in most major emerging economies, including Brazil, remain strong. Our latest projections anticipate sustained global growth of about 5 percent both in 2007, and 2008, with major emerging markets leading the way. However, the balance of risks has tilted to the downside when compared with a few months ago, reflecting the impact of the recent turbulence in financial markets. These risks bear close watching.
7. The principal risk is that financial market developments affect the real economy through declining asset prices, tightening financial conditions with a repricing of risk, and weaker confidence. In such circumstances, the concern would be that consumption could suffer in the United States, producing knock-on effects elsewhere. However, to the extent that financial conditions return to normal, we believe these risks will likely be mitigated, as most corporations remain highly profitable and household finances continue to be sustained by solid employment growth. Thus, the U.S. economy should continue to grow at a moderate pace this year.
8. We note, furthermore, that the global expansion is not powered by US consumption alone. Despite some slowing in the second quarter, growth in the euro area and in Japan is expected to continue at a solid pace of around 2½ percent, and major emerging markets like China and India will grow at close to or above double digit rates, thereby increasing their contributions to global growth. Indeed, China will be one of the main engines of world growth this year. Several of the major emerging markets have strong economic fundamentals, including current account surpluses and lower debt levels. More flexible exchange systems and the ability to issue debt in local currency have minimized two sources of vulnerability, compared with previous episodes of financial market strains. There is clear evidence of this at present.
9. What we see so far in financial markets is a re-appraisal of risk. This is a natural response—particularly following an extended period of rather exuberant credit markets—and this re-appraisal, in the long run, is good for financial stability. This does not mean that market adjustments do not present medium-term risks. The troubles in the U.S. nonprime mortgage market may further distress the holders of such mortgages and their creditors when adjustable rate mortgages are reset over the remainder of this year and next. In markets outside of the United States, some problems related to exposures to U.S. credit markets have recently surfaced. The liquidity support provided by various monetary authorities has been an appropriate response to an unwarranted and temporary loss of confidence in money markets, related to uncertainties over the extent and distribution of credit-related losses. We believe that liquidity conditions will return to normal as information problems diminish and transparency improves. Although it is too early to assess the final impact of this episode of financial turbulence on real economic growth, a moderation of global growth would have little effect on the fundamentals of the world economy.
Financial market development and growth
10. The events of recent weeks do not undermine the case for financial market development and integration. Concerns over credit quality have led to sharp price corrections in a number of credit-related asset markets. Actually, what we are seeing is a test of new markets and instruments under less flexible conditions than those that prevailed over the last few years. However, the spillover to noncredit markets—including currencies and equities—has so far been manageable, helped by solid fundamentals not only in more developed markets but also in emerging economies. And, if history is any guide, even when shocks in one region spill over into other markets, these effects are typically short-lived and sometimes even provide a necessary wake up call to investors who may be underestimating the risks.
11. Indeed, the advantages of sound financial markets are well known. These markets play a critical role in mobilizing savings and in allocating them to productive investment. Moreover, strong local markets can also provide a more stable source of financing for the public and the private sectors, insulating them to some extent against volatile global capital flows. We have recently seen some practical demonstrations of the positive effects of sound financial markets. In several industrial countries, such as the United States and the United Kingdom, financial markets over the past decade have substantially improved economic performance, through the development a wide array of products that allow for a more efficient allocation of savings. This rapid financial development has helped boost growth in both countries. For example, since the mid-1990s, productivity has grown by about 1 percent a year more in the United States than in the euro area. And almost half of this difference is accounted for by differences in productivity in the financial sector. Similarly, several countries in Latin America have made good progress in developing their financial markets. Pension and mutual funds in Chile have helped lengthen maturities and deepen financial markets. Similarly, both Brazil and Chile have developed foreign exchange derivatives markets which are among the most sophisticated and transparent in the world. These developments are helping to enhance stability and economic growth.
12. Indeed, it is no coincidence that the countries—in Latin America and elsewhere—where financial market development has been the most advanced are also those that have been among the most successful economies. The causality runs both ways. As macroeconomic policies have become more credible, and confidence grows that inflation will remain low, demand for financial services increases. As financial markets grow, the availability of credit increases, spurring faster noninflationary growth. And as financial markets become more sophisticated, and risk management and hedging become easier, economies become better able to manage volatility. In this context, I should mention that the Fund has recently completed a study on what countries need to do to maximize the gains from financial globalization. We find that countries that have more developed financial sectors, stronger institutions, sound macroeconomic policies, and more open trade systems are better placed to benefit from financial globalization and are considerably less likely to suffer the instability that greater openness to global capital flows could entail.
Building stronger financial markets
13. What then should emerging market countries do to promote strong financial sectors? The answer is a familiar one. Governments need to put in place clear and consistently applied regulatory frameworks and to maintain strong financial supervision, while reducing unnecessary legal and regulatory impediments to the smooth functioning of these markets. These are difficult challenges, but experience in advanced economies and in some emerging economies suggests some paths to follow and some mistakes to avoid.
14. One of the great successes of recent years in advanced economies has been the development of thriving markets in mortgages and consumer credit. We are seeing the downside of poor risk assessment and overlending at the moment, but we should not forget the benefits that come from increased access to credit. The broadening of access to credit has created opportunities that would not have otherwise existed. More people can finance a house, buy a car, or build a business than ever before. An increase in economic opportunities also makes it possible for individuals to spread their consumption better over the course of their lives.
15. Latin America, unfortunately, has been largely left behind in this process. Only around one-third of the adult population has an account in a financial institution, compared with more than three-quarters of the population in industrial countries. Similarly, at the end of 2005, household credit in Latin America averaged about 9 percent of GDP, compared to rates of 12 percent in emerging Europe, 27 percent in emerging Asia, and 58 percent of GDP in more developed markets.
16. Clearly, the fundamental condition for the development of all credit markets, including household credit, is macroeconomic stability. We have learned time and again that credit markets will only take off when uncertainties about inflation, interest rates, and the exchange rate are reduced to reasonable levels. However, there are also steps that can also be taken at a more micro and institutional level to promote household credit and mortgage markets. Here there are welcome signs of progress in the region:
• Household credit in several countries, including Brazil, has been increasing rapidly due in large part to important institutional changes that have lowered loan-recovery risks and widened the range of credit vehicles.
• The effort in Brazil to develop technology that allows banks to partner with retailers and other point-of-sale locations also provides a successful model of how to expand access to financial services to new customers and less populated areas.
• The flow of workers remittances to Latin America offers a unique opportunity to widen the financial services net and meet the needs of this traditionally underserved population. Progress is being made in this area as banks become increasingly involved in facilitating the transfer of remittances into the region.
• Another clear lesson is for governments to avoid the temptation to direct commercial bank credit or excessively intervene in product design. Although the recent experience in the United States illustrates that regulators should require credit institutions to make adequate provisions for riskier forms of credit, such as negative amortization mortgages, it is just as important to avoid policies that limit the ability of financial intermediaries to effectively allocate credit to its most productive use.
• A strong supervisory framework is fundamental. Measures to promote credit should be accompanied by a strengthening of financial supervision, which should be alert to new instruments and new potential problems as markets evolve.
• Competition between institutions is important, too. Latin American banks have for many years had much higher interest margins than banks in other regions. Greater competition would help to narrow these margins and there are various steps that could be taken. The passage of regulations to ease the portability of credit and deposits as well as facilitate the sharing of client information can reduce banks' market power over their customers and enhance transparency, which benefits consumers. Brazil has recently moved in this direction and the international experience, including in my own country, Spain, illustrates the dividends that these types of measures can yield.
• Improving the legal environment would also clearly contribute to progress. For example, countries can adopt enabling reforms in the regulatory and legal frameworks for securitization, enforcement of collateral, provision and sharing of credit information, and promotion of rating agencies and credit bureaus.
17. At the same time, adequate protections for investors and borrowers should be put in place. Prudential regulation, based on the conventional tools of risk-weighting, capital adequacy, loan classification, and provisioning, is the minimum requirement for a healthy system. In this regard, a clear allocation of regulatory responsibilities is vital. Regulation by national authorities can also usefully be supplemented by implementing codes of conduct developed by local banking and financial organizations, especially in countries with weaknesses in public law and public enforcement. Such mechanisms are likely to be particularly important in regulating new instruments and markets.
18. Emerging economies can also benefit from better truth-in-lending rules and greater financial education. Transparency in lending should be encouraged. This means giving consumers information that is relevant to their choices and to do so in an accessible way—for example, using summary disclosures in plain language. Financial advice should be readily available from governments and regulatory agencies, and—as a longer-term project—governments should pursue financial education. For example, my own country, Spain, has also used the internet very successfully to promote financial education.
19. Another important area for development is corporate bond and equity markets. There are a number of steps that governments and regulators can take to increase the demand for and supply of such bonds. Developing a well-functioning market for public debt helps establish benchmark yields and supplies infrastructure that can be used in other markets. Governments can also ease constraints on pension funds—which are a potential major source of demand. For example, Mexico has relaxed the rules that restrict the investment decisions of privately-managed pension funds, and other countries in the region are also seeking to relax limits on pension fund investment in corporate bonds. Other reforms that would help include strengthening accounting standards, encouraging transparency, and clarifying and improving creditor rights.
20. Derivatives markets can make an important contribution to risk management and risk diversification. Many countries in Latin America do not have derivatives markets, and in others, little depth and often crowded positions accentuate the risk of a sharp correction. Once again, the strengthening of regulatory and legal frameworks, as well as improvements in accounting rules and disclosure requirements, can boost the confidence of investors and financial institutions in using derivatives. For example, Brazil has the largest derivatives markets in Latin America, and part of this success may be due to its transparency as well as to good administration. Brazil is unique among both emerging and mature market economies in having reporting requirements for over-the-counter derivatives markets. Consequently, broader information is available to supervisors than in other markets. The Brazilian experience shows that good data reporting and transparency are neither impossible nor prohibitively expensive in derivatives markets.
21. Let me now sum up. My central message is a simple one: financial markets are becoming ever more important for economic development. Their quality is a critical determinant of countries' economic stability and of their success in a world of financial globalization. Governments, central banks, regulators, and the private sector have a role to play in promoting strong, resilient, and innovative financial markets. Conferences such as this one offer a great opportunity to share ideas and to build on best practices. I wish you a fruitful conversation in the coming days. And I thank you for your attention tonight.
22. Thank you very much.